For the average person, a hedge fund manager is perhaps the first image that comes to mind when thinking of a quintessential Wall Street figure: a guru in a suit and tie shouting orders into the phone, brokering deals that make his or her fortune rich. customers. But recently, reality paints a different picture. After a disappointing year in 2023, portfolio managers were forced to change strategy, with many turning to vanilla index funds to offset poor performance.
Last year represented a rebound for the market as a whole after a dismal 2022, but it still wasn’t kind to hedge fund investors, who expect their money managers to produce returns above market averages. According to data from a recent survey conducted by banking firm BNP Paribas, hedge funds returned 6.67% globally during 2023, 1.5% lower than the expected target rate. By comparison, the S&P 500 produced a 24% return last year, allowing investors who have embraced the simple strategy of investing in index funds to achieve similar gains.
As a result, many of these hedge funds are changing their approaches and investing in index funds, driven by the continued success of large-cap stocks. This trend exemplifies why many retail investors heed Warren Buffett’s long-rumored dictum: Index funds are the best way for an investor to gain exposure to the stock market. Hedge funds are apparently taking notice too.
It may not seem shocking that a portfolio manager would target an investment that generates money—that’s his job. But hedge funds typically don’t invest in index funds. With their high fees, and therefore high net worth investors, these funds are generally involved in more complicated strategies intended for this purpose hit the index funds that are now buying. This emerging reliance on index investing is a clear sign that hedge funds are looking for a lifeline.
Hedge funds invest like index funds
Regardless of the state of the market, a hedge fund’s primary goal is to provide positive returns to its typically high-net-worth clients. However, in 2023, those returns fell well short of what investors and fund managers had hoped for, even as major indexes recovered from the 2022 bear market.
Some of the world’s largest and most renowned hedge funds, such as Citadel’s Wellington fund or Sculptor’s Och-Ziff fund, posted 2023 returns of 15.3% and 12.9%, respectively. While impressive relative to the total, these funds significantly underperformed the S&P 500 Index or the tech-heavy Nasdaq-100, which registered an astonishing 55% in the same period.
One way these hedge funds were able to recover, while still falling short of expectations, was through “index hugging.” — when an actively managed fund (such as a hedge fund) invests more like an index in order to improve its returns.
Data from Goldman Sachs’ Hedge Fund Trend Monitor reveals that hedge funds are narrowing their underperformance to index funds, shifting their portfolio weighting much more heavily toward growth stocks, such as the “Magnificent 7” tech stocks which represent the largest holdings in many indices.–weighted portfolios. Of the more than 700 hedge funds analyzed, nearly one in seven has Amazon, Microsoft and Meta among its 10 largest holdings.
Following Warren Buffett’s advice
Warren Buffett is known for his opinion that the average investor should purchase and continue to accumulate investments in index funds. In 2020, Buffett said that “for most people, the best thing to do is own the S&P 500 index fund, adding “People will try to sell you other things because if they do there will be more money for them.
This no-frills investment strategy is one of the best for ensuring long-term, low-cost gains. However, Buffett’s advice is not necessarily aimed at hedge funds but at individual investors. Indeed, there are multiple problems that arise from hedge funds hugging indexes to achieve returns rather than pursuing alpha (earnings above market benchmarks). One of these is that many hedge funds appear almost indistinguishable from each other as they crowd into the same positions. This could have huge implications if the market worsens and these funds act recklessly and in unison.
Another problem is that investors in these hedge funds do not receive the services they pay for. Hedge funds often require high service fees from their clients, typically a management fee of 2% of the fund’s net asset value and a performance fee of 20% of the fund’s profits plus a minimum investment that typically starts at $100,000 but can vary widely. of 1 million dollars. These payments make hedge funds less accessible to average investors, but if the funds simply buy and hold what index funds hold, then the people who have invested in them are paying a lot more for something that continues to underperform the same indexes that they are trying to imitate.
Whether hedge funds are able to meet their outperformance expectations for 2024 will be a question of reducing investment in mega caps and pivoting to more dynamic strategies. But most importantly for the everyday investor, Buffett’s advice still rings true in 2024; Index funds provide one of the cheapest and most proven ways to invest for long-term growth. Even Wall Street’s imaginative hedge fund managers are embracing this concept, even though they may be silent about it.
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